Companies trade on their own merits again—is the era of the index over?

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Stock market correlation—though falling—is still historically high. Are we really about to witness a more readable stock market?(JP Morgan)

For the last few years, company stocks have had a propensity to “correlate”, i.e., all move together. Individual firms’ fundamentals have been obscured by broad market moves in response to Federal Reserve announcements, panic about the euro, or data about the extent of China’s slowdown. This environment is often hard on investors who pick individual stocks instead of betting on indices, because the extra effort they spend on identifying the best-run companies doesn’t pay off, or can even be counter-productive. For instance, while the S&P 500 rose 13% in 2012, hedge funds, on average, gained just 6.2%.

That appears to be changing, however. For the last few months, correlations have been breaking down. Today, Société Générale’s indicator of trading correlations in the 2,073 companies on the FTSE All-World Developed Index is down 31% since June—its steepest drop since 1993.

The reason for the decline is that a lot of systemic risks have disappeared or diminished. The US put off the worst of the fiscal cliff, Europe has invested so much money in Greece that it doesn’t seem likely to give up now, and Chinese GDP growth came in at 7.8% for 2012—on the higher side of estimates. The VIX, Wall Street’s “fear index,” the standard measure of market volatility, last week hit its lowest level in five years.

With a market apocalypse looking a lot less likely, some investors are forecasting a so-called “secular bull market,” the start of a multiyear market rally. It’s the kind of market stock-pickers love, because their research into companies doesn’t get sidelined by global macroeconomic news. Josh Brown, an investment advisor and the author of the popular blog “The Reformed Broker” gushed last week:

You can’t keep a bull market under wraps for long, especially not one headed into Year 5 that actually seems to be picking up momentum if anything. We’re off to the best January start in a quarter of a century and since 2009 the asteroid has missed earth a few times. Business has continued and profits have been earned in the meanwhile.

But more cautious analysts are warning investors to hold their horses. Marko Kolanovic, an equity derivatives strategist at JP Morgan, explains that uncertainty and the prospect for a sudden increase in volatility are still here; politicians still have more to debate on government spending and the debt ceiling and Europe faces a deep recession and persistent growing pains. He warned in a December note:

The main source of high correlations is macro uncertainty and political risk that is driving the prices of all risky assets…We believe that the prevailing macro uncertainty and structural drivers described earlier in this section will keep the average level of stock correlation high.

Kolanovic elaborates in a phone interview that a lot of the temporary euphoria is probably seasonal, a decline in uncertainty that happens every year. Not to mention the fact that fourth-quarter earnings season, which started in earnest in the US two weeks ago, frequently brings new data on companies, temporarily muffling the noise of macroeconomic events—but those events are still there. “We still think that macro is a big driver and is going to be a big driver of the markets. That will come into play around March,” said Kolanovic.